23 November 1994 External T.I. 9419685 - 9

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether PIP (prepayment penalty payments) received by an investor in a MBS are considered to be on income or capital account

Position TAKEN:

On account of income

Reasons FOR POSITION TAKEN:

When an investor purchases an MBS entitling him to PIP, the PIP become part of his expected return on the investment

Canada Mortgage and Housing Corporation
National Office
700 Montreal Road							941968
Ottawa, Ontario							J.P. Dunn
K1A 0P7

Attention: William Patry

November 23, 1994

Dear Sirs:

Re: NHA Mortgage Backed Securities - Penalty Interest Payments

We are writing in response to your letter of July 28, 1994 wherein you requested the views of the Department regarding the treatment of prepayment penalty interest payments ("PIP") made to a holder of a NHA mortgage backed security ("MBS"). We apologize for the delay in responding to your enquiry.

It is our understanding that a PIP is, generally, a bonus payment made by a mortgagor to the mortgagee for the privilege of prepaying all or a portion of the balance then outstanding under the mortgage. The PIP is usually computed with reference to an interest factor applied to the amount to be prepaid.

As you had noted, Interpretation Bulletin IT-114 published by the Department in August 1973 discussed the taxation of such amounts in general terms. This Interpretation Bulletin was withdrawn on June 10, 1994 as it did not address many of the features present in some financing transactions which have evolved since its original publication in 1974. Accordingly, some of the comments in the bulletin did not accurately reflect the views of the Department which would be applicable to some of these innovative financing vehicles.

It is our understanding that an investor can purchase either a MBS which provides for PIP payments or a MBS which does not provide for such payments. In the event that an investor chooses to purchase a MBS which provides for the flow through of PIP payments, any PIP payments would form part of that investor's expected total return from the MBS and, for this reason, it is the view of the Department that such amounts constitute ordinary income to the investor rather than being received on account of capital.

We trust that this is the information which you require.

Yours truly,

Director
Financial Industries Division
Rulings Directorate
Policy and Legislation Branch